The Sri Lankan economy is likely to face multiple headwinds over the near-term arising from a volatile agricultural sector, a poor consumer outlook as well as rising risks of a balance of payments crisis. However, the industrial sector is likely to recover over the coming quarters on the back of a more stable political climate. As such, we forecast Sri Lanka’s economy to grow at 5.0% in 2017, marking a stabilisation of growth from our forecast of 4.6% 2016. The Sri Lankan government will have to adhere to austerity measures imposed by the IMF under the conditions of a USD1.5bn bailout as the country faces risks of a balance of payments crisis. In line with the bailout conditions, the government will reduce its budget deficit to 5.6% of GDP by end-2016 and 4.7% by end-2017. In addition, the CBSL will be forced to raise interest rates and devalue the currency in order to build a foreign reserves buffer.

However, we believe that the government will face difficulty in making short-term adjustments. The election of President Maithripala Sirisena in January 2015 and the UNP’s victory in the August general election have been broadly positive for socio-political and economic reforms in Sri Lanka. However, we believe the coalition government is likely to stall in its efforts to curb corruption and investigate war crimes that occurred during the civil war (1983-2009). The ability of powerful officials loyal to ex-president Mahinda Rajapaksa to resist these political reforms poses a risk to the country’s political stability and could prompt us to downgrade Sri Lanka’s Short-Term Political Risk Score. Major Forecast Changes The LKR will continue to depreciate steadily as elevated inflation rates and headwinds to growth weigh on the currency.

That said, the government’s progress with fiscal consolidation should boost investor sentiments and encourage greater FDI inflows, which should partly offset some of the depreciatory pressures on the LKR. We have accordingly upgraded our LKR forecasts to LKR151.0/USD at the end of 2016, from LKR155.0/USD previously, and LKR152.9 for the 2017 average, from LKR156.2/USD previously. Against a backdrop of weak performance in the agriculture sector and tighter fiscal and monetary policies, we have revised our real GDP growth forecast for Sri Lanka down to 4.6% for 2016, and 5.0% for 2017, from 5.2% and 5.4%, previously. However, a robust domestic services sector will support growth in the near term.

Table Of Contents

Sri Lanka Country Risk Report Q1 2017Executive Summary 5Core Views 5Major Forecast Changes 5Key Risks5Chapter 1: Economic Outlook7SWOT Analysis 7BMI Economic Risk Index 7Economic Growth Outlook 8Growth Downgrade Amid Headwinds 8Against a backdrop of weak performance in the agriculture sector and tighter fiscal and monetary policies, we revised our real GDPgrowth forecast for Sri Lanka down to 4 6% for 2016, and 5 0% for 2017, from 5 2% and 5 4%, previously However, a robust domesticservices sector will support growth in the near term Sri Lanka's long-term outlook remains positive due to healthy tourism spending andrising FDI in infrastructure GDP By Expenditure Outlook 9TABLE: GDP GROWTH FORECASTS 9TABLE: PRIVATE CONSUMPTION FORECASTS 10TABLE: GOVERNMENT CONSUMPTION FORECASTS10TABLE: FIXED INVESTMENT FORECASTS 10TABLE: NET EXPORTS FORECASTS 10Fiscal Policy And Public Debt Outlook11Fiscal Consolidation Showing Signs Of Progress 11We believe that Sri Lanka will progress steadily in its fiscal consolidation plans The country's improved fiscal outlook will boost investorconfidence and enhance its long-term growth prospects We have upgraded our forecast for the fiscal deficit from 5 9% of GDP to 5 6%of GDP in 2016 and the country remains on track to achieve its 3 5% fiscal deficit target by 2020, based on its ongoing tax reforms However, weak growth and spending pressures ahead of local elections in early 2017 could slow the pace of fiscal consolidation in thenear term Structural Fiscal Position 12TABLE: MAIN REVENUE AND EXPENDITURE13TABLE: FISCAL AND PUBLIC DEBT FORECASTS 13Outlook On External Position 13TABLE: MAIN EXPORT AND IMPORT PARTNERS 14TABLE: CURRENT ACCOUNT BALANCE FORECASTS14TABLE: MAIN EXPORTS AND IMPORTS 14TABLE: CAPITAL and FINANCIAL ACCOUNT BALANCE 15Monetary Policy 15Further Tightening To Control Excessive Credit Growth 15The Central Bank of Sri Lanka (CBSL) held its Standing Deposit Facility and Standing Lending Facility Rate s steady at 7 00% and8 50%, respectively, at its monetary policy meeting on September 28 We maintain our forecast that the CBSL will hike its benchmarkrates by 50bps by end-2016 as credit and money supply growth remain rampant, but note that risks to our forecast are weighted to thedownside Monetary Policy Framework 16TABLE: MONETARY POLICY FORECASTS 16Currency Forecast 17LKR: Stabilising On A Depreciatory Path 17We believe that the LKR will continue to depreciate steadily as elevated inflation rates and headwinds to growth weigh on thecurrency That said, the government's progress with fiscal consolidation should boost investor sentiments and encourage greater FDIinflows, which should partly offset some of the depreciatory pressures on the LKR We have accordingly upgraded our LKR forecaststo LKR151 0/USD at the end of 2016, from LKR155 0/USD previously, and LKR152 9 for the 2017 average, from LKR156 2/USDpreviously TABLE: BMI CURRENCY FORECASTS 17ContentsChapter 2: 10-Year Forecast 19The Sri Lankan Economy To 2025 19A Constructive Long-Term Outlook 19Sri Lanka's economy has grown strongly since the conclusion of the 26 year-long civil war in 2009 and we believe the island is wellplaced to sustain its economic growth momentum over coming years Although the overheating remains an ongoing risk for theeconomy, the reintegration of resources (particularly labour) into the formal economy and a deepening of financial markets bode well forrobust economic expansion over the medium term As such, we expect Sri Lanka's real GDP growth to aver age 5 8% over the next 10years TABLE: LONG-TERM MACROECONOMIC FORECASTS 19Chapter 3: Political Outlook 21SWOT Analysis 21BMI Political Risk Index21Domestic Politics22Resistance To Political Reforms Poses Risks To Short-Term Stability 22Sri Lanka's coalition government will continue to stall in its efforts to curb corruption and investigate war crimes that occurred during thecivil war (1983-2009) The ability of powerful officials loyal to ex-president Mahinda Rajapaksa to resist these political reforms posesa risk to the country's political stability and could prompt us to downgrade Sri Lanka's Short-Term Political Risk Score Sri Lanka'sheightened political uncertainty could dent investor confidence and reduce inflows of FDI and development funds TABLE: POLITICAL OVERVIEW 22TABLE: STALLING REFORMS LIKELY TO WEIGH ON SHORT-TERM POLITICAL RISKS 23Long-Term Political Outlook 24Major Challenges In Coming Decade 24Maithripala Sirisena's election to the presidency in January 2015 and the UNP's victory in the August 2015 general election will set SriLanka on a path of increased political accountability over the coming decade, and greater economic reforms Sirisena's biggest politicalchallenge will be to reconcile the Tamil minority with the Sinhalese Buddhist majority However, this will not be easy and tensionsbetween the two groups will persist for the foreseeable future Chapter 4: Operational Risk 27Operational Risk 27TABLE: OPERATIONAL RISK 27Business Crime 28TABLE: BUSINESS RESPONSE TO RISK IN SRI LANKA 30Government Intervention 34TABLE: BUSINESS TAXES 34TABLE: PERSONAL INCOME TAX35Chapter 5: BMI Global Macro Outlook39Global Macro Outlook 39Austerity Has Peaked, But Populism Is Not Yet Policy 39TABLE: GLOBAL ASSUMPTIONS 39TABLE: DEVELOPED STATES, REAL GDP GROWTH, % 40TABLE: EMERGING MARKETS, REAL GDP GROWTH, % 41TABLE: MACROECONOMIC DATA and FORECASTS 43

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